Friday, May 28, 2010

It appears the Democratic leadership in Congress has learned nothing from the financial catastrophe spreading like wildfire throughout Europe. It proposes to pay for part of the extension of unemployment and other benefits by increasing capital gains taxes on investment partnerships. Larry Kudlow rips the plan at NRO:

And in true class-warfare style, a small portion of the $200 billion is supposed to be offset by jacking up capital-gains taxes for investment partnerships. If passed, this would reduce investment, jobs, and economic growth, and enlarge the deficit. Higher spending and investment taxing is a true austerity trap.

This business of raising the tax rate on investment partnerships would be a particularly onerous burden on American entrepreneurs. And it would put this country at a decided disadvantage to our competitors in China and elsewhere in Asia (outside of Japan).

Increasing the tax rate on the investment portion of these partnerships (i.e., the capital gains) would boost the penalty rate from 15 percent to 38 percent — and that includes the Obamacare payroll tax on investment scheduled for 2013.

So, instead of keeping 85 cents on the extra dollar earned from high-risk investment, the House proposal would drop the return to only 62 cents — a whopping 27 percent incentive rollback. And by the same amount, it would raise the cost of new capital, draining investment liquidity from the private sector in order to finance government transfer payments.

Nothing could be worse. This is spread-the-wealth in its most crass form.

The provision is drawing fire from investment-management partnerships for what many call a punitive tax that singles out one particular industry. From The Wall Street Journal:

Critics of the proposal say it singles out investment-management partnerships as the only businesses in the U.S. where the value of an enterprise would be taxed as ordinary income if the overall enterprise or part of it were sold. It effectively turns the proceeds from the sale of a business into ordinary income, just because it is an investment-management partnership.

At first, lobbyists advising private-equity firms and hedge funds figured the provision—a 29-page section of the bill filled with cross-references and defined terms—was a drafting error, say several people who have lobbied against the tax changes.

"It is widely understood that when you sell your business, you are taxed at a capital gains rate," said Ms. Olson. "Treating all of the investment manager's gain as ordinary income - without regard to whether it is related to carried interest income—is an extraordinary change in the rules."

To bolster its objection to the provision, a memo produced by Private Equity Council compares a clothing-store business with a real-estate investment partnership.

In a clothing-store business, the owners make money from selling inventory. Those proceeds are taxed at ordinary income rates. They grow the business by investing the company's profits and opening new stores. Over time, they build a workforce, a reputation, and loyal customers. When the owners decide to sell the business, the gains on that sale are generally taxed at capital gains rates. (Any inventory on hand is still taxed as ordinary income.)

In a real estate investment-management partnership, the owners invest in properties through funds with outside investors. They reinvest some of the profits in the business, grow their funds, and build up a reputation with investors. Under the proposed rules, when the owners decide to sell the business, the gains on that sale would be taxed at ordinary income rates instead of capital gains.

One potential buyer of investment-management firms said there could be unintended, negative ramifications of the proposed tax change.

"The consequences of these actions might boomerang," said Dean Barr, managing partner of Foundation Capital Partners, a firm set up to buy minority stakes in large alternative investment firms. "I don't think anybody would really like large private-equity firms and hedge funds to move to less-regulated domiciles."

A fancy way of stating the obvious: you may tax them out of business or you may just tax them out of the country.

The good news if there is any, is that the Democrats are beginning to feel the pressure. The bill has been reduced from its original $200 billion to $92.5 billion, and it isn't expected to pass the House until late today, pushing its consideration by the Senate until after the Memorial Day recess which ends June 7.